Saving the Euro

The management of the Eurozone debt crisis is dysfunctional. In our assessment,
to save the Euro, policy makers must focus on competitiveness, common sense
and communication. If policy makers strived to achieve just one of these principles,
the Euro might outshine the U.S. dollar.

Communication

Let's start with the simplest of them all: communication. In a crisis, great
leaders have a no-nonsense approach to communication: providing unembellished
facts, a vision, a path on how to get there, as well as progress reports. Just
as in any crisis, such a leader typically only has limited influence on the
events playing out, but serves as a catalyst to rally the troops, provide optimism,
avoid panics, explain sacrifices that must be taken, and show people the light
at the end of the tunnel. The Eurozone needs a communicator. It can even be
more than one.

The one unifying face of the Eurozone is Mario Draghi, head of the European
Central Bank (ECB). Better than his predecessor, Draghi is able to articulate
the issues and has been lecturing political leaders on their job when it comes
to, among other things, fiscal sustainability and structural reform. Draghi
has made it clear that while liquidity is abundant in the Eurozone, it is rather "fragmented";
as such monetary policy is not the bottleneck, instead, governments and regulators
must live up to their duties. However, Draghi is the first to point out that
he cannot be the spokesperson for fiscal and regulatory matters.

Merk
Insights provide the Merk Perspective on currencies, global imbalances,
the trade deficit, the socio-economic impact of the U.S. administration's
policies and more.

Starting at the top, the executive branch of the European Union is the European
Commission, headed by José Manuel Barroso. Interested in the vision
Europe so desperately needs? Barroso's
vision should give the answers; unfortunately, it comes across like a school
essay, unlikely to go down in history as the vision that saved the European
project. Google is proof that his office must do better in communicating with
the public: the Commission's website ranks third in results when explicitly
searching for it.

Olli Rehn, EU commissioner on monetary affairs, is the public face for the
political side of the euro. While Rehn has achieved much given the limited
authority he has been given, we urge him to take a bigger public profile. In
announcing the Spanish bank bailout, his office released a statement saying " that
the Commission is ready to proceed in close liaison with the ECB, EBA and the
IMF, and to propose appropriate conditionality for the financial sector." The
statement goes on to read "The Commission is ready to proceed swiftly with
the necessary assessment..." - an action plan would have been preferred.

The EBA referenced above is the European Banking Authority, established only
in 2011. The head of the EBA is Andrea Enria. Who? If the Eurozone wants to
move towards a "banking union", Enria needs to work harder in becoming a household
name. As of this writing, the latest headline on the EBA's website appears
ill suited for public consumption: " Consultation paper on draft implementing
technical standards on supervisory reporting requirements for liquidity coverage
and stable funding". Amongst important topics that have not been addressed
in the Spanish banking bailout is what authority the European Banking Authority
(EBA) will have in restructuring Spanish banks. Cronyism has left its regional
lenders, the cajas, uncompetitive. Finland's Prime Minister Katainen
lamented after the announcement of the Spanish bank rescue, " there must
be a possibility to restructure the banking sector because it doesn't make
sense to recapitalize banks which are not capable of running" - the concern
is fair and should have been pre-emptively addressed by the EBA. Instead, in
typical Eurozone fashion, the meddling is eroding trust. For goodness sake,
this is supposed to be a €100 billion bank bailout, not a textbook approach
on how to squander yet another opportunity to tame the debt crisis.

Instead, in explaining the Spanish banking bailout, conservative Spanish Prime
Minister Rajoy bragged to his domestic audience about how Spain avoided a bailout
(really?). Some polls suggest 80% of Spaniards have "little or no" confidence
in him - that's half a year after his party won an absolute majority (if it's
any consolation, the public trusts his Socialist opponent even less). In our
assessment, based on the attributes outlined of what the communication skills
of a great leader may be, Rajoy flunks on all accounts. Rajoy appears more
interested in playing games of chicken with Eurzone leaders than in real reform.
But we are getting ahead of ourselves.

Competitiveness

Communication can only do so much. No bank bailout for Spain will get its
economy back on its feet if Spain is not an attractive place to invest in.
No bailout will cure Greece, unless capital wants to come to Greece. Differently
said, austerity is the easy part; structural reform is the tough job. The key "encouragement" to
engage in structural reform has come from the bond market: the higher the cost
of borrowing for governments, the greater the incentive to get one's house
in order. Unfortunately, a side effect of the bailouts is that such incentive
may be lost. Spanish Prime Minister Rajoy is proof of that: whenever the pressure
of the bond market increases, reforms are promised; the moment the pressure
abates, these promises are watered down.

While Rajoy encompasses just about all that's wrong with the Eurozone process,
it's the (lack of) process rather than the person that is so detrimental. In
Spain's example, painful austerity measures have been implemented. Now, Rajoy
argues, it's time for European leaders to step up to the plate and do their
part. But last time we checked, deficits continued to pile up. Rajoy has argued
that measures that are too draconian now are unwise. Unfortunately, it takes
years to build up confidence, but it can be destroyed in relatively short order;
once destroyed, an enormous effort must be undertaken if confidence is to be
regained. Half-baked solutions won't appease the market. To reduce a youth
unemployment rate of over 50%, make it easier for companies to be formed and
conduct their business, easier to hire and fire people. Pumping money into
a non-competitive banking system won't lead to a sustainable recovery.

The "fiscal compact" policy makers are calling for is happening by default,
as an increasing number of countries give up sovereign control over their budgeting
in return for funding from the IMF and Eurozone. Similarly, the path towards
a "banking union" appears to be shaping up through bank bailouts, as countries
asking for help will have to yield control over their banking system.

And while we have been bashing Spain, Germany is about to destroy the competitiveness
of its banking system. In order to win the required 2/3rds majority in parliament
to pass the "fiscal compact", the German government needs approval from the
opposition. To get such approval, the Merkel government is proceeding with
the introduction of a financial transaction tax. London, New York and Singapore
ought to write thank you letters. It might be more prudent to let peripheral
banks fail than to potentially jeopardize the long-term competitiveness of
the Eurozone banking sector.

Common sense

Unfortunately, with more centralized management through bailout regimes, the
focus shifts from improving the local economy towards managing the bailout
regime, trying to maximize the money that can be extracted from the rescue
funds. Instead, common sense solutions should be a top priority. Since the
Spanish banking bailout is the most recent example, let's ponder a few questions:

Why would you keep your money in a Spanish bank? In the U.S., some
people put their money into community or other local banks, but many put their
deposits with large, national banks. Similarly, why would you put your money
into one of the Spanish cajas, even if well capitalized, when you can
open up an account with Deutsche Bank? Could it be that the Spanish banking
sector is too large? Could it be that, rather than propping up failed institutions,
the government should focus on attracting capital from any institution that
wants to come to Spain? Could it be that the focus should be on making Spain
an attractive place to invest in?

Why do we have national bank regulators rather than a pan-European regulator? Well,
in 2011, the European Banking Authority (EBA) was created. Yet, it's the national
bank regulators that dictate how domestic banks are run. And guess what, national
bank regulators declare domestic debt to be risk free, and as such, banks would
typically not put capital aside against their own national debt. Banks are
in the business of managing risk, but if they are told to classify something
as risk-free that is clearly risky, they may be wise not to touch their own
sovereign debt with a broomstick. Germany, the poster child in this crisis,
is one of the countries that has historically been reluctant to yield power
to Brussels (although they are portrayed as more pragmatic these days). We
would shed no tears to see the German bank regulator BAFIN yield authority
to the EBA. Remember when banks published their sovereign debt holdings last
year at instructions of the EBA? Well, BAFIN wanted to give German banks a
free pass. Fortunately, market forces prevailed (by selling German bank stocks
and debt) and encouraged the voluntary publication of the data.

And why does the ECB not take a lead in creating a 'banking union' by converting
national central banks to divisions of the ECB? Currently, when money
flows from Spain to Germany, the Bank of Spain incurs a liability at the
ECB; in return, the Bundesbank has a claim against the ECB. In a true currency
union, such flows should not matter. Instead, a formerly cryptic measure,
TARGET2, that measures such flows, is closely followed as an indicator of
capital flight from the periphery. To eliminate the concern that a country's
exit from the Eurozone could poke a major hole in the ECB's balance sheet,
the ECB should merge the national central banks, turning them into ECB divisions.

Empower the people, not the bureaucrats. Policy makers must find a
way for local governments to own their own problems. When things fail, local
governments must be held accountable. It cannot be that the Dutch, Finns and
Germans are blamed for the Greeks failing to meet their goals. Some claim this
may only be achieved when countries have independent currencies. However, there
might be a better way: ECB President Draghi has urged policy makers to clearly
define roles, deadlines and conditions to be satisfied. Crises will happen
periodically, but they are far less stressful if sound institutional processes
are in place. The ire when things go wrong can then be directed at the party
responsible. This is not rocket science, but sounds like common sense to us.

In our assessment, the euro has been mostly weak because of the utterly dysfunctional
process. The good news may be that, in our assessment, this isn't a European
crisis. The bad news is that, well, this is a global crisis. As such, should
the process improve, the crisis may target other regions in the world. The
U.K., the U.S., and Japan are some of the candidates. Unlike the Eurozone,
the U.S. has a current account deficit; as such, the U.S. dollar may be far
more vulnerable than the euro has been should the bond market ever be less
forgiving about fiscal largess in the U.S. As we have argued for some time,
there may not be such a thing as a safe asset and investors may want to take
a diversified approach to something as mundane as cash.

As I am wrapping up this analysis, EU Commissioner Barroso is starting a more
public campaign for a banking union, suggesting that the biggest banks across
the EU submit themselves to a single cross-border supervisor. The Bundesbank
is already pushing back, arguing this might equate to a back door Eurobonds.

Please make sure to sign
up to our newsletter to be informed as we discuss global dynamics and
their impact on currencies. Please also register for our upcomingWebinar
on June 13 where we will discuss the investment strategy and objectives
of the Merk Absolute Return Currency Fund. We manage the Merk Funds, including
the Merk Hard Currency Fund. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard
money, macro trends and international investing. He is considered an authority
on currencies.

The Merk Absolute Return Currency Fund seeks to generate positive absolute
returns by investing in currencies. The Fund is a pure-play on currencies,
aiming to profit regardless of the direction of the U.S. dollar or traditional
asset classes.

The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies
versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies
that may include, but are not limited to, the currencies of China, Hong Kong,
Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea,
Taiwan and Thailand.

The Funds may be appropriate for you if you are pursuing a long-term goal
with a currency component to your portfolio; are willing to tolerate the risks
associated with investments in foreign currencies; or are looking for a way
to potentially mitigate downside risk in or profit from a secular bear market.
For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges
and expenses of the Merk Funds carefully before investing. This and other
information is in the prospectus, a copy of which may be obtained by visiting
the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please
read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in
currency exchange rates will affect the value of what the Funds own and the
price of the Funds' shares. Investing in foreign instruments bears a greater
risk than investing in domestic instruments for reasons such as volatility
of currency exchange rates and, in some cases, limited geographic focus,
political and economic instability, and relatively illiquid markets. The
Funds are subject to interest rate risk which is the risk that debt securities
in the Funds' portfolio will decline in value because of increases in market
interest rates. The Funds may also invest in derivative securities which
can be volatile and involve various types and degrees of risk. As a non-diversified
fund, the Merk Hard Currency Fund will be subject to more investment risk
and potential for volatility than a diversified fund because its portfolio
may, at times, focus on a limited number of issuers. For a more complete
discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk
Investments LLC, and reflects the current opinion of the authors. It
is based upon sources and data believed to be accurate and reliable. Merk
Investments LLC makes no representation regarding the advisability of investing
in the products herein. Opinions and forward-looking statements expressed
are subject to change without notice. This information does not constitute
investment advice and is not intended as an endorsement of any specific investment.
The information contained herein is general in nature and is provided solely
for educational and informational purposes. The information provided does
not constitute legal, financial or tax advice. You should obtain advice specific
to your circumstances from your own legal, financial and tax advisors. As
with any investment, past performance is no guarantee of future performance.